The selloff in GBP pairs after Brexit presents a challenge for a trader. At first glance, the strategy for the key GBP pairs, mainly that of the GBP/USD and GBP/JPY, should be simple. The GBP is in vertical short, falling almost in a horizontal line; therefore, the trader should apply a vertical short strategy. But when it comes to the GBP, and for that matter, any pair trading at multi-decade lows, the game plan should be slightly different. So without further ado, here are some tips to trade the GBP after Brexit and any pair that is under its historical lows.

GBP: Two Risks

In the aftermath of the GBP Brexit meltdown, GBP pairs, such as the GBP/USD, have two major risks that we have to navigate around – direction and momentum.

Direction – Since we are talking about multi-year lows, we cannot know when the bottom will emerge, because the pair is in uncharted territory.

Momentum – Again, we have no way of knowing when the momentum will change from vertical bearish movement to a trend to a possible range bound.

So how do we handle those unknowns? We use strategies that minimize the risk from the elements.

Buy on Hammer Reversal

As we can see in the chart below, and as is common when a vertical short occurs, after the vertical short comes a brief bounce. What indicates that that bounce is coming is a hammer reversal candle. A hammer reversal candle is a candle where the middle is long and the opening price and closing price are very close. Once we get a hammer reversal candle we can expect a small bounce.

To increase our confidence in an upcoming bounce we can and should combine a MACD indicator. If the MACD indicator suggests weakening momentum, we get a confirmation. Once we get our confirmation it is a signal to buy; our limit should be set below the opening price of the first full bearish candle of the latest vertical short.

Why should we use this strategy? When we have no indication as to when the pair will bottom out, it’s hard to take a short without risking a sudden bounce back. Normally, it’s less advisable to trade but, under the current conditions, this pattern gives us a chance to reduce the risk of the unknown and minimize the time we are exposed to a choppy market.

Sell on a Major Pull Back

At some stage, every short, no matter how strong, gets a major pull back. That will be our first real opportunity for a short entry. Once we get a major reversal, and by major I mean at least 38.2% of a Fibonacci retracement, then we will get our opportunity to short. That’s because no bearish trend ends without at least two attempts at the same low. That means that, at such a stage, we are no longer in an unknown and our target is the pair’s lowest point.

It’s important to note that when a pair experiences a major retracement it usually signals the end of a vertical short movement and thus is a signal for us to stop using our hammer reversal strategy.

Our limit is now known, aka the low of the pair. And our signal to short can be varied, as in trading a short under any other circumstance. Oscillators such as the MACD, Average True Range and the Stochastic Oscillator can help us time the resumption of the bearish momentum and ride the bearish wave.

But what’s important to understand here is that after a major retracement, it’s much safer to start trading on a longer term and ride a bearish wave.

In Conclusion

Although those insights have been implemented on the latest meltdown in GBP pairs, the tactics we learned here are not only useful for the GBP but can prepare you for the next FX pair meltdown, whether it’s the Euro pairs or the Brazilian Real pairs. What those tactics teach you is how to trade a rather risky situation with plenty of uncertainty. Sure, it is still risky to trade a currency in a meltdown, but at least, with the tactics above, you can avoid the major pitfalls.

This is the first financial event since 2008 that’s hit the mainstream public. Even my friends from college are talking about the Brexit on Facebook.

My Dominari system only trades during the UK evening, so I felt comfortable leaving my system on overnight. When I woke up, however, I didn’t feel the same. Did you see the GBPUSD chart? Holy cow! 1,300 pips in an hour.

GBPUSD lost more than 1,790 pips in a day from top to bottom on the Brexit.

This is the first time I’ve intervened in a trading system since April of last year. What makes me very happy, though, is that this intervention is all about protecting profits. I’m up 6.69% since I began trading the finalized version of Dominari on April 15.

Dominari isn’t intended to trade these types of markets. So, instead of deciding to “see what happens”, I’m flat and happy until we see how the markets open after the weekend. I expect big gaps. I don’t feel like gambling which way the gaps may go.

If you clicked the original link, you noticed that the equity curve is marching straight up. That’s what’s supposed to happen. But like any good system trader, I wanted to see it working in the real world before I upped the capital commitment.

Earlier this month, I decided to trade a second account at FXCM, this time in USD. That brings my total accounts to €8,500 and $5,100. That’s about $14,600 in USD terms between the two accounts.

The FXCM account started live trading on June 6. Before then, I made sure to test it on an FXCM demo account to confirm that my edge wasn’t completely dependent upon broker selection. I’m happy to report that the FXCM results are closely mirroring those at Pepperstone.

Back in the black! The return for the month was 1.03%. It’s not a huge gain, I concede, but a win is a win.

The lifetime equity for QB Pro

Performance didn’t really go anywhere this month. We floated 2% above and 2% below zero most of the time.

The QB Pro performance for September 2015 only

QB Yen came in again at a minor loss -0.61%.

The performance for QB Yen only, Sept. 2015

I’m a bit disappointed with the QB Yen performance so far. Nothing seems wrong other than bad timing turning it on on my part. It’s still hard to take it on the chin for 5 months running, though.

The hedge

I manually hedged the portfolio earlier this month by buying USDCNH in a pullback from of all the chaos. The portfolio took it hard when the yuan was loosened up. I figured that any further volatility would likely stem from USDCNH weakness.

The Chinese are actively intervening in their currency. As we all know from the GBP in the 1990s and the CHF this year, interventions work until they don’t. The main point of concern for me is the rollover cost. It is quite expensive to maintain the position.

The thing that makes me comfortable with that trade is that there is no chance of China miraculously healing. It’s in debt up to its eyeballs – everything from corporates all the way up to regional governments. And while China doesn’t want the yuan to devalue too quickly, the absolute last thing it would want is for the yuan to rise in value.

I cannot conceive of any plausible scenario where China manages to return to the 7-10% annual GDP growth that it experienced for 30 years. Too hot, too fast. If you have a plausible scenario in mind, then write your ideas in the comments section.

Updates to the strategy

I’ve promised many updates to the strategy over the past 6 months. Jingwei and I have evaluated them all. All of the proposed changes came up far short of my expectations and were thus not implemented in the live account.

I’m working with Jingwei, our actuary, to develop new trading systems. You’re going to learn the newest indicator in a few months.

The changes alluded to in the post are all different from QB Pro. I’ve flogged that strategy about as much as I can.

I feel good about QB Pro long term. Before anything potentially good happens in the account, however, I really need the Fed to get off the bench. Raising rates would be good for us because it should kick off a long term USD trend. Another round of QE would be the best thing for the strategy. I personally despise QE and think it’s a bad idea, but it would ignite a massive USD selloff. That’s the kind of market where QB Pro has done extraordinarily well in the past.

Here’s the US dollar index for the past year:

The US dollar index for the past year.

And for easy comparison, here’s the same QB Pro lifetime equity chart. Notice that performance peaked around mid-March and has been flat ever since.

The lifetime equity for QB Pro

Things should pick back up whenever the dollar picks a direction. I expect that to happen by year’s end. Nobody will believe the Fed if they punt one more time on a rate increase in December.

In the meantime, all of this research has given me the great epiphany that the strategy works best where pairs are trending. The portfolio is being rebalanced this month accordingly.

As with virtually any trading scenario, we must first determine the direction that we need to trade the pair for the greatest likelihood of success.

By looking at the historical 4 hour chart of the GBPUSD below, there are several reasons we know that we want to go long (buy) the pair. Price action is above the 200 Simple Moving Average and is pulling away from it. The pair has been making higher highs (green lines) and higher lows which indicates an uptrend. Also, at the time of this chart, the GBP was the strongest currency and the USD was one of the weaker currencies.

All these point to a buying opportunity.

But, the question remains, when do we enter the trade?

Here’s where we bring in the trendline…

Let’s take a look at the historical 4 hour chart of the GBPUSD pair below…

We can see that price action has come in contact with trendline support at several points – note the blue boxes.

Since price has tested and respected the trendline for at least three “touches”, we know that our trendline is valid.

Our entry strategy to buy this pair using trendline support will be to wait for price to trade down to the trendline and into the “Buy Zone”. If price trades into the Buy Zone and stalls and a candle does not close below trendline support, just as in our blue box examples, we can take a long position on the pair with our stop just below the trendline or just below the lowest wick that penetrates the trendline.

The trader could exit the trade if price reaches resistance, the previous high, or by employing a simple 1:2 Risk Reward Ratio.

Now let’s take a look at a historical 4 hour chart of the USDCHF for an example of selling against Trendline Resistance in a downtrend…

This trading scenario will be virtually the opposite of what we did in the previous buy example.

We want to sell the pair a it has been making lower lows (red lines) and lower highs. Price action is below the 200 SMA and pulling away from it. Also, at the time of this chart, the USD was weak and the CHF was strong.

Again, price action has tested our resistance line at several points (the blue boxes) so we know the trendline to be valid. In this example we would wait for price to trade up to trendline resistance in the “Sell Zone”. As long as a candle does not close above the trendline, we would sell the pair with a stop just above the trendline or just above the highest wick to penetrate the trendline.

The trade could be closed should price reach the previous low or we could use a 1:2 Risk Reward Ratio to exit the trade.

A number of readers are using the scalper EA in live accounts. The number one issue that many of them cited is that my research focused solely on the EURUSD. Does it work on other forex pairs?

Absolutely. However, it doesn’t work on all of them. It’s important to follow the same logical process that explained why the expert advisor works so well on the EURUSD.

Analyze the scalper EA in Excel charts

We must dive back into Excel to evaluate the original hypothesis. My expectation was that the strategy should work on charts where the distance of the price from the 200 SMA forms a nice inflection midway through the curve.

The frequency of various distances of the price from the 200 SMA on GBPUSD.

The area right around the 0.5% marks the inflection point. As a reminder, you can think of the curve as being composed of two parts. There’s the steep part, which is where the price is highly likely move. Then there is the flat part. That means the price drifts instead of moves.

Think of slope as rate of change. A steep slope means a fast rate of change. The price is likely to be anywhere but here on the next bar.

Flat slopes make for slow rates of change. The price is in fact very likely to remain a similar distance from the SMA in future bars.

The graph contains 2 slopes. A steep slope and a flat slope. Both are marked in red.

The strategy only works when price is likely to stay in the same spot. We are, after all, scalping. The opportunity only exists when the expert advisor can trade in the chop. The chop only exists when the slope of the frequency line is flat.

I used my experience on the EURUSD to infer that 0.75% would make for a natural starting point to evaluate for the moving average envelope. It’s far away enough from the inflection point to overcome spread costs, but close enough to yield a solid number of trading opportunities.

The initial results came out even better than the EURUSD. These results do not include slippage, commissions or spread costs.

GBPUSD Results

Results for 2011 for the scalper EA on GBPUSD

The results are very much in line with the original idea. Percent accuracy stayed in the same ballpark, coming out to 81%. The profit factor jumped very nicely to 2.99, which is substantially better than the EURUSD performance of 2.16. The sample size consists of 113 trades, which is enough to infer a reasonable expectation of performance.

Equity curve of the scalper EA on GBPUSD for 2011.

The final test is “does it make money when including trading costs?” The answer is yes. On a 2.5 pip spread, the total trading costs of standard lots on 113 trades is $25/lot * 113 lots (trades) = $2,825. That number is substantially less than the raw profit of $5,360. It makes sense to trade this strategy.

The final step of walking forward unfortunately doesn’t offer enough data points to draw a conclusion. It only placed 13 trades for the entire year. It broke even.

USDCAD scalping stats

Performance for USDCAD 2011 with a band of 0.9%.

Equity curve of USDCAD for 2011

USDJPY is a bad idea

The frequency graph for the USDJPY looks much, much different than the other currencies. Instead of being steep and mostly flat, it’s more like free falling and perfectly flat. The massive size of the tail and the severe contrast between the steep and flat portions led me to believe, correctly, that trading USDJPY would not be a good idea.

The frequency of various distances of the price from the 200 SMA on USDJPY.

Although the areas near the inflection point are indeed the most profitable, the profit factor for USDJPY plummets to slightly above 1.0. When trading costs are factored in, it doesn’t make sense to trade.

Trade performance for the scalper EA for USDJPY in 2011

Related

Have you read the article explaining how and why the scalper EA works?

If you have any suggestions on how to make the rules apply to more currency pairs or instruments, then please share in the comments section below.